Tax Management Transfer Pricing REPORT Volume 8 Number 21 Wednesday, February 23, 2000 issn1521-7760 Text Documents GERMANY Revised German Cost Sharing Arrangemen Regulations [Issued 12/30/99; Translation by Deloitte Touche GmbH in Dusseldorf] This translation is not official or binding, but for information purposes only. Federal Ministry of Finance B4-S1341-14/99 Berlin, 30 December 1999 Supreme Tax Authorities of the States For information: Federal Tax Academy Federal Tax Department Principles for the examination of income allocation by cost sharing arrangements between internationally related enterprises Referring to the outcome of the discussions with representatives of the supreme tax authorities of the states, the following applies to the examination of income allocation by cost sharing arrangements between internationally related enterprises: 1. In General This letter is intended to provide guidelines for the application of the arm's length principle if internationally related enterprises structure their relationship in the form of a cost sharing arrangement. The individual reimbursement of services is not affected regardless of whether the transfer price is determined according to the direct or the indirect metho 1.1.Definition Cost sharing arrangements are agreements that are concluded by internationally related enterprises to perform or receive services for the parties'mutual interest during a particular period of time by cooperating with each other in a p The services must be pe est of the receiving enterprises and in the expectation of a benefit, for instance in creased income. The services may relate to auxiliary functions of the pool Such cost sharing arrar f a cost pool. The costs may affect all types of services, for example assets, administrative or other services. In this context the where applicable only the deductible amount thereof-are to a key based on the respective ben efits of the pool members ternal partnership without establishing a partnership or a permanent e Page 1Tax Management Transfer Pricing Report-Revised German Cost Sharing Arrangement Regulations
1.2. Pool members Only enterprises with corresponding interests may become members of the qualifying pool, i.e. only enterprises that use the services rendered to the pool in an economically identical way The services are combined for the purpose of joint acquisition, development or production of assets services or rights in order to draw a mutual benefit from the combination of the member's resources or abilities. Accordingly, participation in a cost sharing arrangement is restricted to enterprises that themselves derive a benefit from the services they perform for the internal partnership, i.e. to enterprises that make use of their share in the results of the joint activities In a research and development pool, for example, holding companies and patent exploitation companies would pursue interests that are different from those of production companies; therefore, they annot become members of the same research and development pool. This does not exclude the possibility, however, of such companies entering into exploitation agreements with the pool Contractual partners of a pool that perform services in the interest of the pool members and do not use or exploit the results of these services(mere contractors cannot be included in the cost sharing arrangement(see clause 1.7) 1.3. Cost sharing arrangement Following commercial practice a cost sharing arrangement has to be concluded in advance in writing 5). The terms and conditions of the cost sharing agreement must be observed cumentation( see clause must meet minimum requirements and must be accompanied by appropriate do 1. 4. Services Except for demand pools(see clause 1. 7)the services of a pool may be performed by one, by several r jointly by all pool members. Thus, an exchange of services does not take place since the allocated costs are to be treated as the pool members'own deductible expenses se he enterprises receiving the services can be granted a claim which is limited in type and scope of services, i.e. to request services individually or to place orders with the enterprise providing the service f different types of services are supplied these services have to be recorded and valued separately for each type, e.g. if a pool member performs research and development services and also provides administrative services of a different type 1.5. Exclusion of double charges If costs have been allocated and charged on the basis of a cost sharing arrangement the service ecipient must not be charged again, e.g. by invoicing for goods or services Under a cost sh arrangement there can be no separate charge for the transfer of intangible assets the transfer of know-how or the transfer of services, that according to the cost sharing arrangement can be claimed by the pool members 1.6. Capitalizati According to sec. 5 subs. 2 Income Tax Act intangible assets created within the scope of the cost sharing arrangement must not be capitalized. For the capitalization of entrance payments see clause 4.1 1.7. Performance of services by non-pool members Dool), e.g. a contract researcher. The pool must be charged an arms length price for the services of the The pool can also receive services from a related party that itself is not a member of the pool related party(see Federal Tax Court decision of 23 June 1993-Bundessteuerblatt 1993 ll page 801). If there are no appropriate arm's length prices the services should be calculated using the cost plus method The amount charged to the pool must be allocated to the pool members The companies of the M-group, A, B, C, are situated in different countries and so far have undertaken eir research activities on their own. To avoid inefficiencies they establish a research pool in which the research activities are exclusively allocated to A. A's expenses associated with those activities are 126. B exercises coordination activities, since the research pool also receives services from related company D B's expenses associated with the coordination activities are 6 and d's expenses associated with the research activities are 60 Page 2Tax Management Transfer Pricing Report- Revised German Cost Sharing Arrangement Regulations
The companies A, B, C will participate in the results of the cost sharing arrangement in equal shares A B c D Expenses Profit mark-up Total Cost allocatio 65 Reimbursement Payment 2. Allocable amount 2.1. Computation of costs The allocable amount is calculated on the basis of the direct and indirect expenses that have actually been incurred and that are economically related to the services already performed or to be performed in the future. Basically, the expenses must be calculated according to the accounting provisions of the country in which the service provider conducts its business activities. The deductibility of the costs allocated to a German service recipient is determined in accordance with German Tax Law e.g. sec. 160 General Tax Code and sec. 4 subs. 5 Income Tax Act. The expenses must be clearly defined. If several pool members provide the agreed services the expenses can be determined in accordance with a single national set of accounting provisions or based on the accounting principles applicable for a consolidated balance sheet of the companies, provided that such a procedure is not opposed by the tax administrations of the countries in which the services are performed Income(including subsidies and allowances)that is economically related to the expenses must be matched with the expenses. The same applies to special tax advantages, e.g. special depreciation allowances. If a license fee for intangible assets that have been created under the cost sharing agreement is received by the pool, the allocable amount must be reduced by this fee If individual services are performed in kind by the pool members this will not be regarded as a transfer of assets but rather as a surrender of the use and benefit the value of which is to be determined based on e expenses incurred. In the case of tangible assets which have already been written off, their fair market value at the time of surrender and their remaining useful life have to be taken into account. With regard to intangible assets it is allowable to estimate the expenses by an appropriate license fee less the usual profit mark-up The allocable costs may include interest on the employed equity capital that is shown in the tax balance sheet; the interest rate must equal the credit rate for the currency of the state in which the activities are exercised If expenses for different services are charged according to a uniform cost sharing arr nt these xpenses must be determined separately for each service type(see also clause 1. 4 para. 3 Set-offs are not allowable between individual service types or with other services outside the scope of the cost sharing arrangement 2. 2. Profit mark-up Page 3Tax Management Transfer Pricing Report -Revised German Cost Sharing Arrangement Regulations
A profit mark-up on the allocated costs cannot be accepted from a tax point of view with regard to the joint purpose of the pool and the absence of an entrepreneurial risk for the service provider. This does not affect clause 2.1 para. 4 3. Cost allocation 3. 1. Principle The costs are allocated on the basis of the benefit that each pool member may expect. The exp developments that can reasonably be expected at the date of the conclusion of the agreement. The basis for the cost allocation as well as the allocation key are to be determined accordingly. If different services are combined in a cost sharing arrangement the benefit for each service is to be determined separately A prudent and diligent manager will not participate in a cost sharing arrangement if it is obvious in advance that he can obtain comparable services easier and in a more favorable way in the form of separate transactions. Accordingly, a prudent and diligent manager will not continue a cost sharing arrangement in its existing form if it becomes obvious after some time that the cost allocation is unfavorable compared with the receipt of comparable services that would be charged separately Non-quantifiable benefits based on group affiliation cannot be taken into account when determining the benefit of the cost sharing arrangement. The arms length principle does not exclude a deduction of charges for research and development pools that proved to be unsuccessful. An allocation based on a cost sharing arrangement can only be accepted if the allocated costs do not permanently exceed the arm s length price for the services provided. An allocation based on a percentage of the turnover of the service recipient, regardless of the actual cost base or a similar allocation key, cannot be accepted for tax purposes 3. 2. Allocation key The allocation key to be chosen must be the most objective one in the individual case. If several keys are equivalent the selection of the key is in the discretion of the manager. The allocation key may be taken rom e.g. the used produced, sold or expected units of a product line, the material used, the machine work per hour, the number of employees, the wage total, the value added, the invested capital, the business profit and the turnover the circumstances in the individual case might lead to other allocation criteria. Thus, for example an appropriate allocation key may also consist of the weighted combination of different factors 3. 3. Adjust After an appropriate period of time unrelated parties will review whether the benefits actually incurred are consistent with the anticipated benefits, the time for a review will be determined by the degree of uncertainty inherent in the assumptions employed. Important changes must lead to an adjustment of the cost charges, i.e. a regular adjustment of the allocation key would be necessary. If the review is performed on a timely basis the adjustments will be prospective only 3. 4. Collection of charges final invoicing on the basis of the actual expenses must be made before the balance sheet for thee In case of prepayments or if the cost charge is based on budgeted expenses(budget projections) respective fiscal year has been prepared 4. Special 4. 1. Late entry Enterprises that join an existing cost sharing arrangement have to make a buy-in payment if the existing pool members transfer tangible or intangible results of the pool activity to the entering party. The buy-in payments are determined in accordance with the arm's length principle. The results might consist of, for example, intangible assets, semi-finished activities or know-how acquired during the preceding ctivities. This means that payments for unsuccessful research activities might have to be taken int account as well. this rule applies if a prudent and diligent manager would have required or paid a consideration for the increase of the know-how associated with the existing results. if the know-how of the new member is already nearly equivalent to that of the old pool members a buy-in payment will usually not be necessary. In all cases of buy-in payments the existing pool members transfer a part of their shares in the results from their former activities to the new participant. The acquiring enterprise must capitalize its If, on entrance to the pool, a member makes a contribution in kind in lieu of a buy-in payment or for Page 4Tax Management Transfer Pricing Report-Revised German Cost Sharing Arrangement Regulations
other reasons clause 2.1 para. 3 will apply accordingly. If the cost sharing arrangement refers to administrative services a buy- in payment usually will not be applicable 4.2. Early withdrawal, termination If pool members withdraw in advance and derive additional benefits from the results that they have attained so far, e.g. by third-party exploitation, or if they burden the remaining pool members with additional costs, an arm's length buy-out payment may be considered to reimburse the remaining pool members. This rule always applies if the withdrawal of a pool member leads to an identifiable and uantifiable reduction of the value of the continued cost sharing arrangement, e.g. because the remaining ool members transfer or assign rights in intangible assets, semi-finished activities or know-how created under the scope of the cost sharing arrangement to the withdrawing partner if the cost sharing arrangement merely refers to services that are jointly acquired by the pool members and for which the pool members are continuously making payments, a buy-out would not be imposed on a member that leaves the arrangement If, after the withdrawal of a pool member, it appears that the results attained to that point will only benefit the remaining pool members a compensation payment to the leaving pool member might be justified. This rule always applies if the withdrawing party transfers its property rights from the cost sharing arrangement to the remaining pool members If the participants terminate a cost sharing arrangement each of them is entitled to that share of the ool's results that corresponds to those contributions that during the contractual duration of the pool have been paid to the pool either in the form of buy-in payments or as compensation payments 4. 3. Change of agreement If the cost sharing agreement is changed to a license agreement and the contractual parties waive their rights to the results of the cost sharing agreement in favor of the future licensor(s )they must receive license agreement without transferring the rights at the results of the cost sharing agreement to the If the participants terminate an R&d cost sharing agreement and if the agreement is replaced by licensor the existing pool members must be allowed to use the acquired know-how and the intangible assets that have been created, at least for a transitory period The cost allocation is not subject to a withholding tax based on sec. 50a subs. 4 Income Tax Act. allocated the rights to the intangible assets claims the entire foreign withholding tax in its tax return the 3 Withholding tax imposed on license fees for licenses to third parties that benefit all pool members ca be claimed only proportionately by the individual pool members If the pool member who has formally been emaining pool members must be compensated accordingl If a foreign pool member makes available the use of intangible assets to a domestic service-providing ool member, withholding tax will be imposed on the consideration if the requirements of sec. 50a subs. 4 Income Tax Act are met. the imposition of the withholding tax is not affected if the consideration is offset against the allocated costs 5. Documentation and evidence 5.1.1. Form and content A qualified cost sharing agreement must be in writing; it must comply with the following minimum requirements; if necessary, appendices, enclosures or additional agreements have to be provided as well 1. Names of pool members and other related beneficiaries 2. detailed description of the contractually agreed services 3. determination of the costs to be allocated the method of cost calculation and possible deviations: 4. determination of the benefits expected by the respective participants Page 5Tax Management Transfer Pricing Report-Revised German Cost Sharing Arrangement Regulations
5. determination of the allocation key 6. description of how the value of the initial and the later service contributions of the pool members will be determined and allocated coherently to all pool members; 7. type and extent of inspection of accounts(e.g. in case of cash in advance; date of inspection) 8. provisions regarding adjustments if circumstances change 9. contractual term 10. provisions regarding the termination of the agreement as well as, if necessary, the prerequisites and consequences of the entrance of new pool members and the early withdrawal of existing pool members 11. agreements on the access to the documents and records regarding the expenses and the service of the service pro 12. allocation of the usage rights stemming from central pool activities in case of research and 5.1.2. Documentation of expenses and services The services received by the pool members and the expenses associated with them must be verifiably documented. This applies in particular if different services are combined in a uniform cost sharing e arrangement. If indirect costs are allocated the basis for the allocation is to be documented. Incor earned in association with the cost sharing arrangement must be recorded separately 5.1.3. Documentation of the expected benefit The determination of the expected benefit is of particular importance. The expected benefit can I illustrated by problem analysis, project reports, target descriptions and similar documents. The documents ust also indicate to which extent other group members might gain a benefit from the cost sharing 5.1. 4. Documentation of service recipient The documentation of the service recipient must contain 1. The cost sharing agreement including appendices, enclosures and supplements 2. if not already part of the contract or contained in the contractual appendices: documentation to justify the allocated costs in particular with regard to the expected services, the expected benefit, the allocation key and the allocation criteria(extent of the benefit in comparison to other service recipients causative and use-oriented cost allocation) 3. agreements on advance payments 4. annual settlement of the expenses actually incurred: itemization of the total expenses in respect of cost centers and their allocation to the pool members; classification of the direct and indirect expenses according to cost types, e.g. labor costs, travel costs, office rent, depreciation for wear and tear, third party licenses, EDP costs, storage expenses; proof of payment; 5. documentation of services actually received and benefit gained, e.g. monthly, quarterly or annual ports on individual services and projects of the service provider, correspondence, visitors' reports minutes of meetings regarding individual projects; research reports, list of patent applications, press pleases, start of production of new products, improvements or innovations in the production of old 5.2. Evidence Principally, the cost sharing agreement can only be taken as a basis for the allocation of the taxable income if the documentation requirements are met. According to the provision of sec. 90 subs. 2 General Tax Code the tax authority is allowed to request information, documents and evidence as necessary in the dividual case. Therefore, the service recipient must immediately submit the documents of the service provider on request of the tax authority 6. Deficiencies in the cost sharing agreement If the cost sharing agreement contains serious deficiencies, such that a prudent and diligent manager would not have participated in such an agreement, the deduction of business expenses will be refused. If a prudent and diligent manager would have participated only with a smaller payment, the deduction of Page 6Tax Management Transfer Pricing Report-Revised German Cost Sharing Arrangement Regulations
(sec. 62 General Tax Code). In other cases, e.g. if the allocation cannot be proved due to a lack or o business expenses would be admissible only to that extent. The deductible amount is to be estimat expenses. In this context the tax authority might make assumptions that are supported by a certain appropriate documentation, the tax authority might also estimate the admissible deduction of busines probability. 7. Repeal of the administrative principles Clause 7 of the principles for the examination of the income allocation for internationally related enterprises(administrative principles)of 23 February 1983(Bundessteuerblatt I p 218)is repealed 8. Transitory rules Adjustments of existing cost sharing arrangements resulting from the aforesaid explanations must be made by 31 December 2000. If no adjustments are made clause 6 shall become applicable By order certified employee 0 Copyright 2000 by The Bureau of National Affairs, Inc., Washington D.C. Page 7Tax Management Transfer Pricing Report-Revised German Cost Sharing Arrangement Regulations
